The fall in earnings has meant necessary changes
The decline in earnings by companies, both those oriented towards domestic markets and foreign markets has been large and swift.
There is data available for the export market indicating a large decline, but little for the domestic market. But we know for the domestic market the decline in the production of services is very dramatic: Eduction, health care, retail trade, personal services, banking, hotels, and restaurants have all experienced sharp declines in employment and production.
Loss of employment of informal workers has been particularly extensive. Manufacturing may be less affected, although demand is certainly dropping for many products. Construction has slowed with most private sector projects stopping work. Production for exports dropped by 80% in April.
It will improve this month but it is unclear by how much. The impact of this on the banking system is equally devastating. Many enterprises will not be able to make the full payment on their loans. Although there is a present restriction on classification of loans until June 30, eventually the loss of income from rising NPL must be managed.
BB has recently issued a circular that instructs banks to not charge borrowers interest due or to collect installments falling due, for April and May 2020. The interest charges can be placed in a separate account but there is no decision on the ultimate disposition of these. (The accounting framework for this instruction is not clear; the issues are complicated.)
The purpose of the circular is to reduce the financial burdens on non-banking enterprises of managing their outstanding loans, enabling these enterprises to maintain their stability. But the circular will also have a profound impact on the banks and the banking sector.
This note estimates this impact might be and suggests an alternative approach.
Loss adjusted for two months: Tk14,800cr3. Impact on capital
Estimate total capital 12.5% of total risk assets (Tk10,52,400cr x 125%) x12.5% is Tk164,400cr.
Loss of capital in two months: 9.0%
Notes: On revenue the investments are the unencumbered assets listed in liquidity table for January 2019 as reported in BB, Major Economic Indicators Monthly Update March 2020. We assume 7% is the average return.
We think that disbursements of loans during the two months April and May will be limited Tk5,000cr for RMG workers that earns 1% for the bank and Tk2,000cr that earns 9%. As this will only earn interest for 11 months, we have slightly overestimated the amount but it is small and has no impact on the conclusion.
On costs we assume the cost of interest paid is 7%; the 7% is based on the fact that as time deposits role over from their level of 7-10% the average would be 7% over the next 12 months, all reaching 6% after roll over.
Time deposits are taken as equal to January 2020 per Monetary Survey, Major Economic Indictors March 2020. We keep time deposits constant with no growth through May 2020.
If borrowers fail to repay an installment of the loan that would not impact the P&L statement until or unless the loan was classified.
In that case there would be additional provisions taken as a cost. As BB does not allow any classifications we ignore for this calculation the impact of increased defaults of principal.
We assume that capital requirements are met in January 2020. Risk weighted assets are taken as 1.25 times advances [credit to the private sector from the Monetary Survey.] We have not included non-funded assets here; our attempt to estimate these indicated that the change is small and has no significant impact on the conclusion.
a. The individual banks will show losses of these amounts and reductions of capital to match this aggregate estimate. This will have a clear impact on bank share prices. Investors will be uncertain as to how long this circular will continue and will be likely to sell bank shares. It will be hard to find buyers if the share price is not allowed to decline. However, there may be sales not registered correctly at the stock market or with side deals that lower the actual sales price even though the price of record conforms to the no decline allowed. But the true value of every bank will decline.
b. The rule of maximum exposure of one borrower to 15% of a bank’s capital will now be widely violated and Bangladesh Bank must provide some time to allow correction of the excess exposures.
c. Reduction in bank capital, with uncertainty of how long the circular will remain in place, will lead to continuing loss of confidence in Bangladesh banks increasing the price of participation in trade financing and L/C acceptance. The costs to Bangladesh enterprises are currently four times Indian costs and twice Pakistan costs. The circular that blocks charging interest for two months will make relations of Bangladesh banks with foreign banks increasingly difficult. Continuation of the circular past May 2020 will continue erosion of capital with growing negative international ramifications.
d. Currently loans cannot have their classification changed until June 30. Under current conditions loans are very likely to move towards classification during the next six months. The costs of NPL have not been included here but these will be significant.
Alternative approach: There is a much better way to achieve the objective sought without harming the position of the bank. This approach makes clear that there is no forgiveness of interest but that it is deferred. To achieve this interest coming due along with any principal installment is converted into a term loan with a grace period and a five year repayment period; interest rate 9%.
Each month that BB wants to continue this would add on a new term loan. BB can extend the period during which this rescheduling applies and hence defer the immediate burden on the company but keeps the unpaid interest and principal payments as liabilities of the borrower. No additional collateral would be required for these mini term loans.
In this scheme the interest that should have been paid will be booked as income [one can book a percent of the income due with that percent being the ratio of performing advances to total advances.] The bank’s P and L statement now looks more or less as it would be without the circular.
Bangladesh Bank would have to lend money to each bank equal to the amount of new accounts opened; this keeps the capital position of the commercial bank unchanged.
Bank liquidity: BB must be particularly vigilant of the liquidity position of the commercial banks, particularly third and fourth generation banks during the period of the implementation of the circular. A subsequent article on monetary policy will address this issue.
Forrest Cookson is an economist who has served as the first president of AmCham, and has been a consultant for Bangladesh Bureau of Statistics.